Phantom Oil Reserves

2016 was a year of reports of disappearing oil which then seemed to mysteriously reappear.  Headlines such as “Huge Decline in US Proved Oil and Gas Reserves”, “US Producer’s Oil Reserves Plunged 12% in 2015”, “World Oil Reserves Stable Despite Drop in Investment – BP” were typical, implying a crisis – or not, depending on your reaction to them.  Mainly they revealed a lack of understanding of “Reserves”, what they are and how they are determined by “analysts”, financial institutions, and newsletter headline writers.

In the course of discovering and developing an oil field the first estimate of the amount of oil in an exploration target is by geologists and geophysicists who have studied the area and identified the target.   They estimate the amount of oil which has formed in an area and the amount collected in a reservoir.  Engineers become involved to plan the development and production of the field and they forecast development schedules, costs for development and operation, production rates, and revenues.  These forecasts result in estimates of the amount of oil to be recovered from the reservoir.  These are technical forecasts and an important management tool.

Converting these technical forecasts of future production to Reserves and Present Values estimates are an accounting and regulatory activity.  Reserve estimates and their Present Value are required by regulatory agencies in a few oil-producing countries for companies with stock that trades on stock exchanges.  Regulatory agencies establish rules for determining these reserves, calculating their Present Value, and accounting for them and their costs on financial statements.  These jurisdictions and the regulatory agencies are primarily the US (Security and Exchange Commission, Financial Accounting Standards Board), Canada (Toronto Stock Exchange), and the UK (Petroleum Reserves Management System, Financial Reporting Commission).  These three jurisdictions do not have uniform rules and regulations.  Therefore, the same forecast can have considerably different Reserves and Present Values estimates in different jurisdictions and be accounted for differently.  I once had the responsibility to report in all three jurisdictions for a property in Texas; with one engineering forecast, the Reserves varied over a range of 80% because of the different reporting rules.

Regulated Reserves and Present Values reported estimates cover about 10% of the world’s oil resources and 15% of its oil production.  The rest of the world’s oil is owned by governments and organizations who have no interest in reporting their reserves or in telling the truth.

Reserves for companies with shares traded on US stock exchanges are generally considered oil that can be recovered under current economic and operating conditions as defined by the SEC.  US reported Reserves fall into two main categories: Proved Developed Producing (PDP) which is the amount of future production from wells already drilled and Proved Undeveloped (PUD) which is the future production from undrilled locations in close proximity to existing wells where wells will be drilled within the next 5 years.  The Present Value of future production is the net income from the future production discounted at 10% per year (PV10).  Reserves and their PV10 values are reported on SEC Form 10-K each year.

I reviewed the 10-K filings for 17 companies active in developing “unconventional” resources to ascertain the effect of the decrease in price on reserves.  For these companies, Reserve reductions due to the price drop are in the range of 10% to 50%; most of the companies are between 10% and 30%.  It was interesting to note that the Reserve decrease is between 30% and 50% for companies that had declared bankruptcy.  For PV10 values, the decrease due to the oil price drop for most of the companies is between 90% and 120%; for companies which had declared bankruptcy, the decrease is less than 75% – a reverse of the expected result.  Decreases of Reserves and PV10 were mostly in the PUD category.   A large part of that is probably due to budget cuts which reduced the number of wells to be drilled within the next 5 years.

These disappearing Reserves quickly reappeared, however.  Programs of infill drilling, expanded fracturing programs, re-fracturing of existing wells, completing wells in new zones, drilling new laterals in older wells, improving production rates from new wells, and acquiring new assets quickly replaced the Reserves lost due to the price drop.

Never doubt the resilience of the American oil industry.

The major point to be realized is that the Reserve reductions due to the price drop are because of accounting and regulatory rules and, although the underlying forecasts may have been modified as to schedule and revenues, the oil did not disappear; it is still there.  Also, the Reserves that replaced the reductions are, in many cases, not the same oil but oil that due to certain actions can be added to Reserves for the first time as new technology and efficiencies increase recoveries.

Therefore, headlines that indicate US Reserves have decreased by 11% or 12% when the oil price drops by more than half are misleading when they characterize such drops as “huge” or a “plunge” and implying these decreases are alarming.  They are not; in fact, such small drops under those conditions show the strength of the industry.  The oil is still there and the reductions are only due to accounting rules.

As noted above, most of the world’s resources are not subject to regulated reporting requirements and therefore world Reserve figures are not modified due to changed economic or operating conditions.  They generally are changed only to reflect new discoveries and are inflated for political purposes.  For instance, Saudi Arabia has had 260 billion barrels of reserves for about 30 years.  During that time it has produced about 75 billion barrels and the economics of the industry have changed dramatically but nevertheless Saudi Reserves remain at 260 billion barrels.  This is known in the industry as due to a Magic Source Rock, a geologic phenomenon which creates new oil at exactly the same rate as the rate of production, year after year.  A headline that indicates that World Reserves remain stable despite a drop of investment is meaningless.